TWN Trade & Development Series 28

Trade, Growth and Industrialisation:

Issues, Experiences and Policy Challenges

YILMAZ AKYÜZ

TWN
Third World Network 1
 Trade, Growth and Industrialisation:
Issues, Experiences and Policy Challenges

YILMAZ AKYÜZ

TWN
Third World Network

2
Trade, Growth and Industrialisation: Issues, Experiences and
Policy Challenges
is published by
Third World Network
121-S, Jalan Utama
10450 Penang, Malaysia.

© Third World Network, 2005

Printed by Jutaprint
2 Solok Sungei Pinang 3, Sg. Pinang
11600 Penang, Malaysia.

ISBN: 983-2729-50-5

3
CONTENTS

Note

1 Introduction 6

2 Trade Liberalisation: Issues at Stake 9

3 Trade Liberalisation and Economic Growth 17

4 Trade Liberalisation and Balance of Payments 22

5 Trade and Industrialisation 26

a. Manufactured exports and value-added 26
b. A stylised picture of diversity in trade and industrial development 30

6 Pros and Cons of Participation in International

Production Networks 33

7 Competition and the Fallacy of Composition 36

8 Policy Challenges 40

References 46

4
NOTE:
This paper draws on research undertaken during the last few years of the author’s
tenure as the Director of the Division on Globalisation and Development Strat-
egies (DGDS), UNCTAD. It was published mainly in UNCTAD’s Trade and
Development Report. An earlier version was presented at the UNDP/NSI/TWN
Conference on Trade: Contribution to Growth, Human Development and Pov-
erty Reduction in Asia held in Penang, on 22-24 November 2004.

5
 1 Introduction

“…the hype about the benefits or costs of trade ... gave the
public, policy-makers, and researchers an unrealistic view of
the role of trade in economic development and growth.”
– Richard Freeman (2003, p. 25)

The belief that rapid and full integration into the global economy would create
more favourable conditions for growth in developing countries has permeated
much thinking in development policy in the past two decades. Openness to
international trade was expected to allow developing countries to alter both the
pace and the pattern of their participation in international division of labour,
thereby overcoming balance-of-payments problems and accelerating technical
progress and economic growth.

The same thinking has also held sway with respect to foreign direct investment
(FDI). Quite apart from the belief that it would provide resources for develop-
ment and balance-of-payments support, FDI has been seen as a crucial factor
for success in trade and industrialisation. It is expected to improve industrial
productivity and competitiveness by bringing new technology, enhancing mar-
ket access or providing a better services infrastructure. More importantly, since
trade has been taking place increasingly within international production net-
works (IPNs) organised by transnational corporations (TNCs) by locating dif-
ferent stages of production of a final good in different countries, attracting FDI
seeking low-cost locations has become increasingly important for participation
in such networks and expansion of trade in manufactures.

6
Rapid liberalisation of trade and capital flows has indeed dominated policy
reforms in many countries in Latin America and Africa in the past two decades.
Starting in the middle of the 1980s many of these countries which faced serious
balance of payments and debt servicing difficulties resorted to big-bang
liberalisation, dismantling non-tariff barriers, sharply reducing tariffs on a wide
range of products, and rapidly shifting from inward-oriented (import-substitu-
tion) to outward-oriented (export-promotion) development strategies. Further-
more, impediments to FDI have been removed and in fact foreign investors
have been provided incentives over and above those enjoyed by domestic in-
vestors.

While some of these “reforms” were implemented as part of stabilisation and

adjustment programmes supported by the Bretton Woods Institutions (BWIs)
or in the context of multilateral trade negotiations in WTO, in many developing
countries neo-liberal policies have found widespread acceptance and support
among policy makers who often resorted to unilateral big-bang liberalisation as
a way of getting out of the debt and development crisis.

While liberalisation has also dominated policy in Asia, the approach pursued
there has been quite different. Compared to Latin America many countries in
East Asia had already been operating under less restrictive trade regimes during
the 1970s and early 1980s, and the liberalisation that has taken place over the
past two decades came after a period of successful industrialisation and devel-
opment, rather than in response to crisis. In South Asia where policies pursued
in the past were similar to those in Latin America, liberalisation has followed a
more gradual and cautious approach, combined with intervention in many ar-
eas of policy, including continued support and protection to domestic industry,
and direction and guidance of FDI, rather than seeking a rapid and full integra-
tion into the global economic system and leaving development to global market
forces.

It should thus come as no surprise that there has been considerable diversity
among developing countries over the past two decades regarding the impact of
trade and investment policies on their economic performance. Many countries

7
with similar trade and investment regimes have had different degrees of suc-
cess in industrialisation and economic growth depending on the conditions un-
der which policy reforms were undertaken. Furthermore, the experience shows
not only that the liberalisation of imports and FDI does not guarantee a strong
export performance, but also that improved export performance is not always
mirrored by acceleration of industrialisation and growth.

8
 2 Trade Liberalisation: Issues at
Stake

Many of the adherents to the view that trade plays a key role in successful
development believe that the main benefits in this area come from unilateral
liberalisation in developing countries themselves. This view is held not only by
free trade enthusiasts in the academic community, but also by the secretariats of
multilateral organizations including the BWIs and the WTO. The World Bank,
for instance, has argued that while a successful outcome of the Doha Round
negotiations greatly improves the growth prospects of developing countries,
these benefits would come primarily from reforms in developing countries them-
selves.

In this so-called pro-poor scenario, it is estimated that 50 per cent of the gains
from global liberalisation of food and agriculture “are reaped by developing
countries, of which 80 per cent is the result of own-reform in these two sec-
tors.” The outcome is much the same for manufacturing where developing
countries would “gain significantly more from their own reforms” than market
opening in industrial countries (World Bank 2004, pp. 50-51). In commenting
on these results the WTO secretariat thus concluded that: “This lesson, that a
large part of the economic gains from trade liberalisation accrue domestically,
should not be overlooked in the context of reciprocal bargaining for market
access” (WTO 2004a, p. 2).

On this view, thus, the success of the Doha Round in promoting development
rests primarily with liberalisation in developing countries themselves. In a sense
this position amounts to a self-denial for the WTO as a forum for give-and-take
multilateral trade negotiations. If taken seriously, developing country trade

9
negotiators should go back to put their houses in order and open their doors,
rather than wasting their time in Geneva!

Until recently, it was believed that trade liberalisation on its own would pro-
duce considerable benefits, particularly to countries pursuing inward-looking
development strategies in Latin America and Africa. However, with the mount-
ing evidence that many of the promises of trade liberalisation have not been
fulfilled, attention has turned not to possible shortcomings in the underlying
premises of the theories advanced in favour of rapid opening up to foreign com-
petition, but to imperfections elsewhere in the economies concerned.

It has thus been argued that trade liberalisation on its own would not bring
benefits if the state continues to intervene in other areas, except for correcting
market failures, and if there are imperfections in other markets.1 In particular,
attention has focussed on the role of labour market imperfections in impeding
rapid redeployment of labour and adjustment in wages in ways necessitated by
the new set of incentives and competitive forces brought about by trade
liberalisation. Similarly, removing impediments to private investment, includ-
ing foreign investment, and improving the investment climate is seen as essen-
tial in realising dynamic benefits of trade liberalisation through improved pro-
ductivity and growth.2

Clearly, some of these imperfections arise from structural weaknesses which

cannot be easily rectified by government intervention, but can only be removed
throughout a long and sustained process of institutional and economic develop-
ment. Although such weaknesses provide a legitimate reason for a cautious and
gradual approach to trade liberalisation, increasingly there has been a tendency
to overlook them and assume that if developing countries are not benefiting

1
For instance it has been argued that the “neoclassical case for free trade (FT) is based on institutional assump-
tions that include a market structure that is complete and a government that intervenes in the markets only to
correct failures, if any, of the market. ... Clearly the efficiency characteristics of FT could fail to hold if any of the
institutional or other assumptions underlying them fail to hold. For example, if externalities in production and
consumption lead to market failures, and the government fails to correct them optimally, or more generally, if
there are domestic distortions, a FT competitive equilibrium need not be efficient”, Srinivasan and Bhagwati
(1999, p. 11).
2
See, e.g., World Bank (2002a, p. 164); World Bank (2004, pp. XV-XVI); and WTO (2004b, section III.C).

10
from trade liberalisation, it is because they are not undertaking reforms in other
areas of policy: that is, the problems arise from omission not commission.

It has for instance been argued by the WTO secretariat that the benefits the
developing countries can derive from trade liberalisation depend on the imple-
mentation of complementary reforms or “getting other policies ‘right’ too ...
and using the negotiations to help push through domestic economic reforms”
(WTO 2004a, p. 2, Box 1). What is advocated has an uncanny resemblance to
the Washington Consensus perspective of “getting prices right” supplemented
by second generation reforms regarding governance and market regulation to
enhance competition and efficiency (WTO 2004b, section II). It also carries the
implications that negotiations in WTO should determine not only the trade re-
gimes, but policies affecting the broader fabric of social and economic life in
developing countries.

Here we also meet a certain degree of circularity in orthodox arguments. It has

long been maintained that most developing countries lack the institutions needed
for successful policy intervention of the kind practised in East Asia. Govern-
ment failure has thus been seen as an important reason for leaving matters to
markets. But now we seem to have come full circle: in order for trade
liberalisation and markets to yield the expected benefits, we need good institu-
tions and governance!

The benefits claimed from trade liberalisation are twofold: static efficiency gains
due to a one-off increase in the level of income, and dynamic benefits due to
faster economic growth. The traditional theory of comparative advantages fo-
cuses on one-off efficiency benefits resulting from reallocation of resources.
Trade liberalisation results in a shift in incentives, profitability and competi-
tiveness of different sectors, and it is assumed that resources, including labour
with various skills, capital and land could be shifted rapidly and without large
costs from those industries losing competitiveness to those gaining. In this
way, part of what was previously produced domestically would now be im-
ported while there would be an increase in production and exports in sectors
enjoying increased competitiveness.

11
In this process, there is no change in the rate of utilisation of resources, but
because of increased efficiency in their allocation, income level is raised once
and for all. The composition of output would change in favour of traded goods
so that there would be an increase in exports and imports as a proportion of
GDP. Trade balance would be maintained throughout as increased imports are
matched by expansion of exports.

These are not just heuristic or simplifying assumptions made in theoretical

models designed to explore the potential benefits of trade liberalisation. They
are also made in the discussion of trade policy and in simulations designed to
explore the likely actual benefits of trade liberalisation. These include the simu-
lations that gave rise to extravagant predictions regarding the gains that devel-
oping countries would reap from the Uruguay Round (Martin and Winters 1996).
They also include recent simulations by the World Bank about the benefits that
developing countries could obtain from further liberalisation in the Doha Round.3
These all use “general equilibrium” models, assuming that markets always clear
and resources are rapidly redeployed and remain fully or equally employed
after liberalisation.

However, the reality is not so simple. Factors of production, including labour,

capital and land, are often sector specific or product specific. A car mechanic
cannot instantly become a textile machine operator, or a lathe used in machine
tools industries cannot be transformed into a sewing machine to be used in the
clothing sector. More generally, expansion in sectors benefiting from
liberalisation requires investment in skills and equipment, rather than simply
reshuffling and redeploying existing labour and equipment. Unless accompa-
nied by such investment, new activities and industries cannot emerge to the
extent needed to replace those displaced by import liberalisation. Investment
would also be needed for rationalisation in existing industries if they are to
survive in the face of greater import competition.

3
World Bank (2004, pp. 47-60). See also World Bank (2002a, pp. 166-179) which also summarises several
studies using applied general equilibrium models (pp. 169-170, Box 6.6).

12
The immediate impact of rapid trade liberalisation could thus be unemploy-
ment, de-industrialisation and growing external deficits even though there may
be a significant increase in export growth. Some of the old industries may
survive through downsizing and labour shedding, and this may lead to improved
average productivity. But the overall impact could be a decline in industrial
employment and value-added as firms that go out of business could not be fully
replaced by new firms in sectors enjoying greater competitiveness.

More importantly, when the initial damage inflicted on industry is deep, the
process of industrial restructuring in response to new incentives may be de-
layed and the economy could remain depressed for prolonged periods. Avoid-
ing such an outcome would require a gradual and phased approach to import
liberalisation, properly sequenced with the build up of a strong and flexible
industrial and export capacity through a judicious combination of market disci-
pline and policy intervention. The East Asian experience holds useful lessons
on how to do this.4

The dynamic benefits expected from trade liberalisation depend on its impact
on sources of economic growth, namely growth in factor inputs and technical
progress. However, unlike the comparative advantage theory of static benefits,
in growth theory there is considerable ambiguity and little consensus about the
impact of trade openness on economic growth. This is certainly the case for
traditional neoclassical and Keynesian theories of growth, and there is nothing
new in this respect in the “new” growth theory. However, there is a host of ad
hoc models designed to show that liberalisation may lift not only the level of
income but also long-term growth, helping to close the income gap with rich
nations.5

Certainly, the one-off increase in efficiency and income that may be brought
about by trade liberalisation could raise the long-term growth rate if it results in
higher rates of saving and capital accumulation. Accumulation could also be
4
There is rich literature on how this was done in East Asia. For some of the key issues see UNCTAD (1994,
Part Two, chap. I; and 1996, Part Two, chap. II), Akyüz and Gore (1996), and several articles in Akyüz (1999).
5
For a discussion of these issues see Rodrik (1996); Srinivasan and Bhagwati (1999); Rodrik (1999); World
Bank (2002a, p. 169, and fn. 17); Winters (2004); and Dowrick and Golley (2004).

13
accelerated to the extent that trade liberalisation accompanies liberalisation of
FDI and/or encourages a sustained inflow of foreign capital. Clearly, the effect
on domestic savings would depend on whether the initial impact on income is
positive. Even when the level of income is lifted by trade liberalisation, sav-
ings may fail to rise to the extent that there is a pent up demand for foreign
consumer goods.

On the other hand, as recognised by the World Bank (2002a, fn. 17, p. 181), a
rise in FDI may not yield long-term benefits in terms of accumulation because
of subsequent repatriation of profits. In any case, increases in FDI are not
always associated with faster capital accumulation. For instance, a large num-
ber of countries in Latin America which resorted to rapid liberalisation of trade
and foreign investment after the mid-1980s enjoyed large increases in FDI as a
proportion of GDP, but in most of these countries gross capital formation as a
proportion of GDP stagnated or fell (UNCTAD 2003, pp. 76-78).

Within the framework of traditional theories of growth, the impact of faster

capital accumulation that may be brought about by trade liberalisation on eco-
nomic growth would be subject to diminishing marginal returns associated with
capital deepening. This problem can be avoided if there is unlimited labour
supply à la Arthur Lewis. However, even then the effect would be transitory,
lasting until the surplus labour is exhausted. Moreover, a poor country with
large amounts of underutilised land and labour can benefit from a “vent for
surplus” through trade, but this depends not so much on import liberalisation as
growth of exports supported by incentives including easy access to material
inputs and credit, and favourable exchange rates.

A more significant impact of trade on long-term growth could be through tech-

nical progress and increased productivity. This can occur in two ways. First,
expanding to markets abroad allows specialisation and exploitation of scale
economies which can, in turn, accelerate learning-by-doing and productivity
growth. Similarly, trade eases firms’ access to foreign technology and knowl-
edge, and widens their choice of capital and intermediate goods, and these too
can lead to faster productivity growth. Furthermore, if trade liberalisation is

14
accompanied by increased greenfield FDI, it could raise productivity growth to
the extent that such investment embodies new and more advanced technolo-
gies.

There seems to be a widening agreement on the productivity enhancing effects

of trade, but considerable uncertainties remain: “Few dispute that trade open-
ness will improve productivity. There is nonetheless great uncertainty about
the channels – greater domestic competitiveness, imports of technology-laden
goods, FDI, export-driven competitiveness – and the magnitude” (World Bank
2004, p. 60, fn. 14). While some of these linkages between trade and productiv-
ity growth may be important, it should be recognised that trade is not the only
conduit for transfer of technology and knowledge.

More importantly, activating many of these channels does not require import
liberalisation but expansion in foreign markets. Particularly, if the main effect
of trade on growth in modern economies is due to large scale production and
specialisation allowing firms to overcome high entry costs and to benefit from
learning, what would be needed is an aggressive export strategy based not on
the across-the-board liberalisation of imports, but on protection and support
delivered reciprocally against performance of enterprises in generating exports,
productivity growth, value-added and employment, of the kind pursued by the
first-tier Newly Industrialising Economies (NIEs), notably Korea and Taiwan.
Again, access of exporters to technology-laden capital goods at world prices
does not require across-the-board liberalisation of imports; it could be secured
through appropriate duty drawback schemes as successfully practised in East
Asia.

The key issue here is the extent to which accumulation and technical progress
in developing countries should be left to global market forces. If governed by
such forces alone, developing countries can successfully operate, at any point
in time, only those activities which enjoy comparative advantage on the basis
of their existing factor endowments, but these forces do not necessarily set off a
rapid process of change towards a higher level of industrial and technological
capacity. As lucidly explained by Gomory and Baumol (2000, chap. 1), we are

15
no longer in the Ricardian world where comparative advantages are closely
linked to natural advantages, with England, lacking sunny slopes, being unable
to match Portugal in wine but enjoying a relative advantage in clothing due to
its green pastures and woolly sheep.

In a modern world, the place of most countries in international division of labour

is determined not so much by their natural advantages as their success in build-
ing capacity and acquiring skill and experience in industries which enjoy econo-
mies of scale and specialisation. But “entry into one of these industries, against
an entrenched competitor, is slow, expensive, and very much an uphill battle if
left entirely to free market forces.... In the wine-wool world, market forces,
driven by demand and natural advantages, led the world to a single outcome. In
today’s world, market forces do not select a single, predetermined outcome,
instead they tend to preserve the established pattern, whatever that pattern may
be.”6 Thus, ironically, the arguments advanced in favour of trade liberalisation
as a way of facilitating learning and productivity growth call for support and
protection in the early stages of development of large scale, specialised enter-
prises, not full exposure of them to foreign competition.

These arguments in fact tally with the proposition first advanced by Friedrich
List that the “superiority of one country over another in a branch of production,
often arises from having begun it sooner. There may be no inherent advantage
on one part, or disadvantage on the other, but only a present superiority of ac-
quired skill and experience.”7 In other words, the recent debate and experience
regarding the role of trade in growth reinforce, rather than refute, the arguments
long advanced in support of infant industry protection. It is also notable that in
most of today’s industrial countries, including Britain, the United States, Japan
and many others, “the policies that were used [for catch-up] are almost the
opposite of what the present orthodoxy says they employed ‘and currently rec-
ommends that the currently developing countries should also use’”(Chang 2002,
p. 19 et seq.).
6
Gomory and Baumol (2000, p. 6). The authors maintain that, for the same reasons, “there are in fact inherent
conflicts in international trade. This means that it is often true that improvement in one country’s productive
capabilities is attainable at the expense of another country’s general welfare” (p. 4; italics in the original).
7
See Gomory and Baumol (2000, p. 156).

16
 3 Trade Liberalisation and
Economic Growth

As in theory, there is also considerable controversy over the empirical evidence

regarding the benefits of trade liberalisation in developing countries.8 A num-
ber of studies which used cross-country data in establishing a positive empiri-
cal link between trade and growth have come under strong criticism because of
their methodological and conceptual weaknesses. In particular, it has been shown
that positive linkages found between trade and growth in such studies depend
critically on specification and measurement.9

A common problem confronted in these studies relates to the concept of open-

ness. While openness should be defined in terms of the policy regime govern-
ing imports and exports, in reality measures used included a number of indica-
tors (such as black market exchange rate premium, real exchange rate distor-
tions, state monopoly over exports, exchange rate volatility, or geographical
conditions) which have little to do with trade policy regimes. These measures
are poorly correlated among them, and it is often the non-trade components of
such measures that provide the link with growth.

These difficulties cannot be overcome by using the alternative measure of what

is called “revealed openness”; that is, the ratio of trade (imports+exports) to
GDP (Dowrick and Golley 2004, p. 40). While this measure is certainly influ-

8
For the main arguments and evidence advanced in favour of trade liberalisation in developing countries see
Sachs and Warner (1995), Frankel and Romer (1999), and Dollar and Kraay (2001).
9
Sachs and Warner (1995) have offered the most cogent version of the “open economies converge” thesis. For
a critical assessment see Rodriguez and Rodrik (2001). For a discussion of the problems encountered in cross-
country studies see Freeman (2003), Winters (2004), and Dowrick and Golley (2004). For a survey of the earlier
literature see Harrison and Revenga (1995).

17
enced by the import regime, there is no one-to-one correlation. The trade ori-
entation of a country depends not only on its trade policies but also on a host of
other factors including economic size, geographical features and natural re-
source endowment. For instance, in some accounts the resistance of African
policy makers to trade liberalisation is advanced as an explanation of the poor
overall economic performance of the continent (Dollar 1992; and Sachs and
Warner 1997). However, estimates strongly suggest that countries in Africa
trade as much as expected if account is taken of these factors; those in Latin
America on average trade less than expected, while the East Asian NIEs trade
more.10 And the high level of trade orientation in East Asia was based on con-
siderable state intervention, not laissez faire.

A second set of problems relates to causality. A positive link between trade

openness and growth does not necessarily indicate that the causation runs from
the former to the latter. It can be quite the other way round. A successful
industrialisation strategy based on a judicious combination of market forces
and policy intervention would not only produce rapid and sustainable growth,
but would also allow imports to be liberalised without generating adverse ef-
fects for industry and growth. By contrast poor growth can lead to increased
pressures for protection. On the other hand, while trade policy itself has an
independent influence on the chances of success of an industrialisation strat-
egy, empirical techniques used cannot always separate its effects from those of
a host of other factors, including macroeconomic and financial stability, ex-
change rate policies, and savings and investment.

Some authors who otherwise believe in the virtues of free trade have also
criticised cross-country regression methodology for reasons of their weak theo-
retical foundations, poor quality of their data base and their inappropriate econo-
metric methodology, expressing a preference for case studies in demonstrating
the benefits of free trade (Srinivasan and Bhagwati 1999).11 However, the evi-
dence from case studies is no more conclusive in demonstrating that countries
with lower levels of trade protection grow faster than others, since they too are
10
UNCTAD (1998 pp. 70-72). A similar conclusion was also reached by Rodrik (1998).
11
The studies in question are older detailed country studies done in OECD, NBER and World Bank.

18
often unable to disentangle the effects of many other factors from those of trade
reforms (Greenway 1993; Rodrik 1999).

It has also been noted that actual outcomes from free trade treaties rarely matched
the expectations of their supporters or opponents (Freeman 2003). Thus, the
European Union performed less well in the decade (1992-2002) following its
move to the single market than in the preceding decade; almost immediately
after signing the Free Trade Agreement with the United States, Canada suffered
its worst economic slide since the Great Depression; and the Mexican economy
collapsed shortly after the United States Congress passed the NAFTA Treaty.
Certainly there were several factors influencing the outcome in such cases.

Nevertheless, a number of studies that tried to isolate the effect of trade

liberalisation from other factors by focussing on micro data found no conclu-
sive evidence on the link between trade liberalisation and growth: “Virtually all
of the studies find that productivity rises in import-competing sectors... In some
cases they attributed the increased productivity to the exit of less efficient im-
porters, in other cases firms invested in capital or squeezed inefficiencies out of
their production process. But in no country was the liberalisation episode fol-
lowed by a noticeable change in the growth rate. From the data on growth, you
could not identify that there had been a policy change” (Freeman 2003, p. 7).

More recent studies have focussed on the impact of trade on capital accumula-
tion and productivity growth.12 While some of these show that a reduction in
import barriers is followed by increases in productivity, this is not always asso-
ciated with an acceleration of growth for the reasons noted above. A recent
study found evidence that an increase in the overall trade share does have long-
term benefits on economic growth primarily through productivity increases,
but such impact varies over time and across levels of development (Dowrick
and Golley 2004). These benefits were greater for poorer countries than for the

12
There are also attempts to incorporate such dynamic effects in the computable “general equilibrium” models,
notably the impact of trade on productivity growth; see World Bank (2002a, pp. 169-170, Box 6.6) and World
Bank (2004, p. 50).

19
more advanced economies during the 1960s and 1970s, thereby promoting con-
vergence. After 1980, as a result of faster liberalisation, trade shares of poorer
countries increased much more rapidly than those of rich countries, but trade
generated substantially greater benefits to more advanced countries, leading to
income divergence.

Indeed, in the period 1980-2000, the impact was negative or negligible for coun-
tries with an initial (1980) per capita income of less than $3,000. A plausible
explanation given is that in previous decades trade liberalisation was combined
with pro-growth policies and institutions and that it was the latter rather than
trade per se which promoted growth. This was not the case in the 1980s and
1990s when trade liberalisation was introduced in a big-bang fashion without
accompanying policies and institutions.

Looking at the broader experience since the 1980s, rapid liberalisation of trade
and FDI in developing countries has indeed resulted in a sharp increase in the
share of trade in GDP as predicted by free trade models. More important, these
countries have become major players in world trade. Their exports have grown
faster than the world average and now account for about one third of world
merchandise trade, rising from less than one fourth in the 1970s (Akyüz 2003,
pp. 1-2). Furthermore, by any count, there have been significant improvements
in macroeconomic policy discipline and overall economic governance through-
out the developing world.

However, the success of developing countries in expanding their exports and

attracting export-oriented FDI, and their progress in “getting other policies right”
has not always been accompanied by faster growth of their GDP. At some 4.8
per cent per annum, the average growth rate in developing countries during the
1990s was well below the average of 5.7 per cent achieved during the 1970s.
Although this is mostly due to poor performance of rapidly liberalising coun-
tries in Latin America and Africa, several countries in Asia too had slower
growth in the 1990s compared to the 1970s. Two notable exceptions are China
and India which have adopted a gradual approach to liberalisation, opening up
to trade and investment without abandoning selective and proactive policy in-

20
tervention. If these two countries are excluded, the decline in the average growth
in developing countries as a whole is much more pronounced.

Indeed the evidence does not support the claim by the World Bank (2002b, p. 4)
that more-globalised developing countries increased their growth rates over
each of the past four decades. This result is due to the inclusion of India and
China as more-globalisers in the World Bank definition, a treatment which can-
not be justified either in terms of the trade shares of these countries,13 or, for
that matter, in terms of their trade regimes. As a result, if China and India are
excluded from the World Bank group of more-globalisers, it turns out that the
“remaining group of ‘more-globalised’ developing countries actually grew more
slowly than the “less globalised” over the period 1980-2000 (Dowrick and Golley
2004, p. 54).

13
In the World Bank definition more globalised countries are those which displayed the highest proportional
increase in their trade share between the late 1970s and the late 1990s. Thus India, which increased its trade share
from 14 to 22 per cent is defined as ‘more globalised’ even though its trade share is well below the average in both
periods. Again the same definition has the effect including China (with its trade share increasing from 14 to 34
per cent) in the Bank’s ‘more globalised’ group; Dowrick and Golley (2004, pp. 53-54).

21
 4 Trade Liberalisation and Balance
of Payments

According to conventional thinking trade liberalisation would not lead to bal-

ance of payments deficits because reallocation of resources would ensure that
increased imports would be matched by faster export growth. As a result, little
attention has been given to the impact of trade liberalisation on imports and
balance of payments in mainstream literature. Rather, there has been a ten-
dency to link balance of payments problems to macroeconomic conditions alone
as, for instance, maintained recently by the WTO (2004b, p. XXI): “Balance-
of-payments imbalances are a reflection of macroeconomic conditions and cannot
be effectively addressed through trade policy.”

While macroeconomic conditions including the pace of domestic demand, fis-

cal deficits, private savings-investment imbalances and exchange rates domi-
nate the behaviour of balance of payments, there can be no denying that trade
regime can have an independent influence on structural deficits. For the reason
already discussed, import liberalisation can result in output loss and increased
trade deficits, and these may not be adequately addressed by currency adjust-
ments, particularly when the capital account is open and the exchange rate is
influenced primarily by capital flows. Under such circumstances, macroeco-
nomic adjustment to higher trade deficits would mean depressing the level of
economic activity and sacrificing growth.

UNCTAD (1999, chap. IV) research indeed shows that trade liberalisation in
developing countries has generally resulted in a structural deterioration in the
balance of payments. After a sharp cutback in imports necessitated by the debt
crisis of the 1980s, both exports and imports accelerated during the 1990s in

22
most developing countries, but spending on imports generally rose faster than
export earnings. This gap between import and export growth rates was particu-
larly large for Latin America. Asia also saw some acceleration in its exports
and imports in the 1990s, but here too, imports rose much faster than exports,
partly due to a surge in capital inflows and currency appreciations, which even-
tually culminated in a crisis in East Asia in 1997. China stood as a major excep-
tion; its exports in the 1990s rose faster than imports, contrary to the trends
observed in previous decades.

For developing countries as a whole (excluding China), the average trade defi-
cit in the 1990s was higher than in the 1970s by almost 3 percentage points of
GDP, while the average growth rate was lower by 2 per cent per annum. An
econometric examination showed that rapid liberalisation of trade in develop-
ing countries, notably in Latin America, together with declining terms-of-trade
and slower growth in industrial countries, played a key role in the structural
deterioration in the relation between growth and the trade balance measured as
a proportion of GDP.

The adverse impact of trade liberalisation on balance of payments has also been
confirmed by a recent study which examined the effects of liberalisation on
imports and exports separately in a sample of 22 developing countries (Santos-
Paulino and Thirlwall 2004). Accounting for all measures taken to reduce anti-
export bias and import controls, including non-tariff barriers and exchange rate
distortions, the study finds that liberalisation has raised export growth by some
2 per cent and import growth by 6 per cent with the result that the trade balance
worsened by 2 per cent of GDP. While the effect is similar across all regions,
including Africa, Latin America and East Asia, it is greater in countries with a
high initial level of protection, i.e. those resorting to big-bang liberalisation.

The authors argue that “countries (and international organisations that promote
trade liberalisation in developing countries) need to take great care in the se-
quencing of the liberalisation of exports and imports to achieve a better balance
between export and import performance if countries are to realise their poten-
tial growth performance. Free trade and flexible exchange rates are no guaran-

23
tee that unemployed domestic resources are easily converted into scarce for-
eign exchange” (Santos-Paulino and Thirlwall 2004, p. 70).

A similar exercise shows that trade liberalisation has widened balance of pay-
ments deficits in Least Developed Countries (LDCs) too, although its impact
on imports, exports and the trade balance has been smaller than for developing
countries as a whole: it “has worsened the trade balance by 1.3 per cent of GDP
in the LDCs compared with 2 per cent in developing countries” thereby exacer-
bating aid dependence and the problem of external financing (UNCTAD 2004,
p. 202).

It is generally recognised that rapid import liberalisation should be combined

with currency devaluation in order to prevent payment difficulties (Edwards
1989; Dornbusch 1990). Furthermore, such a one-off adjustment should be
followed by appropriate management of the exchange rate so as not to allow the
erosion of the effects of devaluation over time. More generally, the experience
strongly suggests that management of exchange rates is considerably more im-
portant than import policy for successful exporting (Agosin and Tussie 1993, p.
22). However, the practice in developing countries during recent years has
often departed from such fundamental principles.

Despite greater exposure to foreign competition, there have been serious short-
comings in exchange rate management in most developing countries, even com-
pared to the interventionist regimes of the 1970s and 1980s (UNCTAD 1999,
pp. 128-131). In particular, liberalisation of capital flows, often prompted by
the need to finance growing fiscal and external deficits, has aggravated pay-
ments difficulties brought about by rapid trade liberalisation, leading to cur-
rency appreciations and instability, thereby undermining trade and growth per-
formance.14

In this respect the experience of China since its accession to the WTO at the end
of 2001 is worth noting. China agreed to make a considerable reduction in its

14
For an analysis of how this has happened in Latin America see UNCTAD (2003, chap. VI).

24
tariff barriers, remove a series of non-tariff measures, eliminate trade-related
subsidies, apply equal treatment of domestic and foreign firms and remove re-
strictions related to local content. But it received very little concessions from
existing WTO members in terms of greater market access, particularly over the
short-term.15

In a sense, therefore, China’s accession to the WTO has resulted in a unilateral

trade liberalisation of the kind undertaken by many developing countries dur-
ing the past two decades. However, it did not constitute a big-bang reform, not
least because it was the continuation of gradual liberalisation pursued over the
previous ten years. Again, China’s liberalisation-cum-accession came out of a
position of strength not weakness. But more importantly, China has so far re-
sisted pressures to liberalise its currency market and capital account, and in-
deed has enjoyed considerable effective depreciation of its currency as a result
of the weakening of the dollar to which it has remained pegged. This has cer-
tainly been a factor in facilitating adjustment to a more liberal trade regime and
avoiding a sharp deterioration of its trade balance. Nevertheless, even though
the export surplus that China has been enjoying since 1993 has so far not disap-
peared, its imports have grown faster than exports and its trade surplus has
fallen as a proportion of GDP.16

15
For a discussion of China’s terms of accession to the WTO see Akyüz (2003, chap. 3), Shafaeddin (2002) and
Li (2002).
16
China’s exports and imports have both more than doubled since joining the WTO. According to preliminary
estimates by the Ministry of Commerce (http://english.mofcom.gov.cn) import growth between 2001 and 2004
exceeded export growth by 8 percentage points on a cumulative basis. In 2002 China enjoyed an export surplus
of some $30 billion, which dropped to around $25 billion in 2003. During the first half of 2004 China’s trade
balance turned negative, but it recovered rapidly in the latter part of the year, estimated to have produced a surplus
of around $30 billion for the year as a whole. Even then, as a percentage of GDP, trade surplus appears to have
fallen from over 2.5 per cent in 2002 to below 2 per cent in 2004. In agriculture where liberalisation was more
abrupt and response to new incentives is typically more sluggish, China has started to run a deficit in the order of
$5.5 billion after enjoying an export surplus by a similar amount in previous years; see Asia Times, January 14,
2005.

25
 5 Trade and Industrialisation

a. Manufactured exports and value-added

The basic policy challenge facing most developing countries is how to establish
a broad and robust industrial base as the key to successful development, and
how best to channel investment and trade to this end. Shifting away from de-
pendence on the production and export of primary commodities towards indus-
trial products has often been viewed as a means of more effective participation
in the international division of labour. Manufactures are expected to offer better
prospects for export earnings not only because they allow for a more rapid
productivity growth and expansion of production, but also because they hold
out the promise of greater price stability even as volumes expand, thereby avoid-
ing the declining terms-of-trade that has frustrated the development efforts of
many commodity-dependent economies.

Indeed, one area of consensus in recent work on trade is that specialisation in

primary exports is bad for growth (Dowrick and Golley 2004, p. 47). In this
respect the recent trade performance of developing countries should be a reason
for considerable optimism, since much of the increase in their exports has taken
place in manufactures, which today account for more than 70 per cent of their
total exports, after hovering around 20 per cent during much of the 1970s and
early 1980s.17

17
The evidence cited in this section is from Akyüz (2003, chap. 1).

26
The share of developing countries in world manufactured exports now exceeds
25 per cent, compared to some 10 per cent in the 1970s. More important still,
many developing countries appear to have succeeded in moving into technol-
ogy-intensive manufactured exports, which have been among the most rapidly
growing products in world trade over the past two decades. For some products
such as transistors and conductors, computers and office machines, and electric
power machinery, developing country exports now account for between 40 and
50 per cent of total world exports.

However, on closer examination, the picture is much more nuanced and less
sanguine. Most countries which shifted from inward-oriented to outward-ori-
ented development through a rapid liberalisation of imports and FDI, particu-
larly in Latin America, have not shared in the expansion of manufactured ex-
ports, but have experienced surges in imports and mounting trade deficits, re-
sulting in increased dependence on private capital inflows for growth. Much of
the expansion in manufactured exports of developing countries has concen-
trated in East Asia and, to a lesser extent, Central America.

This expansion has taken place primarily as a result of the growing participa-
tion of these countries in labour-intensive processes in IPNs organised by TNCs
seeking low-cost producers for export to world markets. As a result, with the
exception of a few East Asian first-tier NIEs, mainly Korea and Taiwan, which
have already reached income levels as high as some industrialised countries,
the exports of developing countries are still concentrated on products derived
essentially from the exploitation of natural resources and the use of unskilled or
semi-skilled labour which have limited prospects for productivity growth and
lack dynamism in world markets.

Trade statistics showing a rapid expansion of technology-intensive, high value-

added exports from developing countries are misleading because of double-
counting of trade among countries linked through IPNs. Such products appear
to be exported by developing countries, but in reality those countries are often
involved only in the low-skill, assembly stages of production, using technol-

27
ogy-intensive parts and components imported from more advanced countries.
As trade flows are measured in gross value rather than value-added, imported
parts and components are counted among the exports of the countries assem-
bling them. Consequently, although developing countries appear to have be-
come major players in world markets for supply-dynamic, high-tech products,
they still account only for 10 per cent of world exports of products which score
high in R&D content, technological complexity and/or economies of scale.

In the past two decades the increased mobility of capital, together with contin-
ued restrictions over labour movements and various incentives provided by the
recipients of FDI, has extended the reach of IPNs particularly in three sectors:
clothing, the automotive industry and electronics. Trade based on specialisa-
tion within such networks is estimated to account for up to 30 per cent of world
exports. In the clothing sector although FDI has played some role, the major
form of production relocation is sub-contracting to domestic enterprises. Elec-
tronics is the most globalised of all industries, and trade in electronics products
is underpinned by an increasing geographical dispersion of TNC-driven pro-
duction networks. Relocation of production in the automobile sector is con-
strained by physical distance to the final market, and is greatly influenced by
preferential regional trade agreements, such as NAFTA and Mercosur.

Almost three quarters of the increase in the share of developing countries in

world manufacturing exports have taken place in the three sectors in which
IPNs have expanded rapidly in recent years. In these networks, notably in elec-
tronics and the automotive industries, most of the technology and skills are
embodied in imported parts and components, and much of the value-added ac-
crues to producers in more advanced countries where these parts and compo-
nents are produced, and to the TNCs involved. The share of developing coun-
tries in value-added is determined by the cost of the least scarce and weakest
factor, namely unskilled and semi-skilled labour, whereas the rewards to scarce
but internationally mobile factors such as capital, management and know-how
are reaped by their foreign owners. It is in effect the labour itself, rather than
the product of labour, that is exported.

28
Consequently, while the share of developing countries in world manufacturing
exports, including high-tech products, appears to have been expanding rapidly,
incomes earned from such activities by these countries do not share in this
dynamism. On this score, a comparison between developed and developing
countries is highly revealing. In G-7 countries as a whole, manufacturing value-
added consistently exceeded manufactured exports over the past two decades,
but the opposite was the case for the leading exporters of manufactures in the
South. Between 1980 and 1997 both developed and developing countries in-
creased their shares in world manufactured value-added at the expense of the
former socialist block, but there was actually a decline in the share of devel-
oped countries in world manufactured exports, from more than 80 per cent to
about 70 per cent.

Developing countries achieved a steeply rising ratio of manufactured exports to

GDP, but without a strong upward trend in the ratio of manufacturing value-
added to GDP. As a result, the increase in the share of developing countries in
world manufacturing exports has not been accompanied by a concomitant in-
crease in their shares in world manufacturing value-added.18

These comparisons relate to value-added generated in developed and develop-

ing countries, rather than incomes earned from manufacturing activities. The
value-added left in developing countries is still smaller and the income earned
by industrial countries is larger if account is taken of profits earned by TNCs on
their investment in developing countries (see Chapter 3).

b. A stylised picture of diversity in trade and industrial development

This general picture no doubt hides diversity among developing countries in

their experience regarding trade and industrialisation over the past two de-
cades. In this respect, it is possible to distinguish among four categories:19

18
For a more detailed account see Akyüz (2003, pp. 39-46).
19
For the evidence cited in this section see Akyüz, Kozul-Wright, and Mayer (2004).

29
• Mature industrialisers: This group includes the first-tier NIEs, notably
Korea and Taiwan, which have already achieved industrial maturity through
a rapid accumulation of capital, growth in industrial employment, produc-
tivity and output, as well as manufactured exports. These economies have
seen a large increase in their shares in both world manufacturing income
and exports over the past two decades. They still have a share of industrial
output in GDP above the levels of advanced countries, but as expected,
industrial growth has started to slow down.

• New generation of industrialisers: These are countries with a rising share

of manufactures in total output, employment and exports, based on strong
investment and upgrading from resource-based activities to labour-inten-
sive manufactures and middle-range technology products. This group in-
cludes the second-tier NIEs (notably Malaysia and Thailand) and China,
all extensively participating in IPNs. However, in these countries indus-
trial deepening has advanced much less than that suggested by their manu-
factured exports. In Malaysia, for instance, between 1980 and 2000 the
share of manufactured exports in GDP increased by 42 percentage points
while the increase in manufacturing value-added as a proportion of GDP
was around six percentage points. In China manufacturing value-added
as a proportion of GDP fell over the same period as a result of rationalisa-
tion associated with a move away from central planning, while the share
of manufacturing exports in GDP increased by some 10 percentage points.
Again the share of all these countries in world manufactured exports in-
creased much faster than their share in world manufactured value added
(Akyüz 2003, p. 45, table 1.5).

• Enclave industrialisers: This group includes countries which have also

moved away from dependence on commodity exports by linking to IPNs
with a heavy reliance on imported inputs and machinery. However, their
overall performance in terms of investment, value-added and productivity
growth is poor. Two countries stand out in this group, namely Mexico and
the Philippines, where manufactured exports as a proportion of GDP rose

30
 rapidly during 1980-2000 while manufacturing value-added stagnated or
declined. It appears that de industrialisation in traditional manufacturing
sectors brought about by rapid liberalisation has not been compensated by
expansion in assembly industries, but as the latter are more export-ori-
ented, there has been a sharp increase in manufactured exports as a pro-
portion of GDP.

• Deindustrialisers: This group includes most middle-income countries in

Latin America, notably Argentina and Brazil, which have achieved a cer-
tain degree of industrialisation but have been unable to sustain a dynamic
process of structural change through rapid accumulation. In a context of
rapid liberalisation, there have often been declining or stagnant shares of
manufactured exports, employment and output, and a downgrading to less
technology-intensive activities. In some countries in this group, notably
Chile, there has been a less destructive pattern of de industrialisation as a
result of a fast pace of investment, accelerating growth based on natural
resources. However, this process now appears to have reached its limits.

With the notable exception of the first-tier NIEs, therefore, recent expansion in
manufacturing exports of developing countries has generally been associated
with their increased participation in IPNs, and generated a more modest growth
in manufacturing value-added in these countries. As a result, developing coun-
tries appear to be a lot more successful when their performance is measured in
terms of manufacturing trade than in terms of manufacturing value-added and
income.

The contrast between the two measures becomes even more evident when a
comparison is made between the structures of trade and industrial output, using
five broad categories of products: primary commodities, labour and resource-
based manufactures, and low, medium and high technology-intensive manufac-
tures. Such a comparison shows that developing countries are becoming in-
creasingly similar to developed countries in the structure of their manufactured
exports, but not in the structure of their manufacturing value-added. But, again,
there is diversity:

31
• Korea and Taiwan stand out for having reached a manufacturing value-
added structure that is by far the closest to that prevailing in the leading
developed countries. In these countries productivity growth over the past
two decades has exceeded the growth in the northern technological lead-
ers, notably the United States, in almost all manufacturing industries.

• The manufactured export structure of a large number of developing coun-

tries extensively participating in IPNs, including China, Malaysia, Mexico,
and the Philippines, has also begun to resemble that of the major devel-
oped countries, but the similarity is much less so for the structure of their
manufacturing value-added. In most of these countries productivity growth
has been faster than in the United States in the lower end of manufacturing
but not in the upper end.

• For the majority of Latin American countries, not only the structure of
manufacturing value-added but also that of exports is much less similar to
those in the more advanced industrial countries. In many of these coun-
tries productivity in labour-intensive manufacturing has been falling, and
the processing of natural resources continues to dominate production and
export activities.

32
 6 Pros and Cons of Participation in
International Production Networks

Taken together, the evidence suggests that among the major developing coun-
tries, only a few first-tier NIEs have succeeded in simultaneously upgrading
their production and export structures by moving into technology-intensive sec-
tors and closing the productivity gap with the industrial leaders. Many develop-
ing countries relying on FDI and TNCs for expansion of industrial production
and exports appear to be far behind in upgrading their production structures,
but they are more successful than commodity-dependent South American and
African economies in moving to manufacturing.

Clearly, participation in the labour-intensive segments of IPNs can yield con-

siderable benefits for countries in the early stages of industrialisation and with
a great deal of surplus labour. It can enable them to increase employment and
per capita income even when the value-added generated is low. This has cer-
tainly been happening in China where transfer of unemployed and underem-
ployed labour from agriculture to export-oriented industries has been an impor-
tant factor in raising per capita income. Furthermore, increased employment of
low-skilled labour in activities linked to IPNs can widen the possible range of
sectors where industrialisation can begin, and help acquire the basic techniques
and organisational skills needed for a more broad-based growth. Participation
in such networks can also help facilitate access to foreign markets. However, it
is also important to recognise the limitations of participation in such production
networks.

33
Industrial upgrading and increased productivity are essential for improvements
in the living conditions of labour force employed by such industries and there
are limits to do this when there is a high degree of dependence on foreign capi-
tal. This is particularly true for middle-income countries which have been suc-
cessful in the early stages of industrialisation but which now need rapid up-
grading and productivity growth in order to advance further along the develop-
ment path. These networks allow TNCs a good deal more flexibility in, and
control over, their choice of investment locations. Moreover, their productive
assets, such as know-how, design and technology, can be locked more tightly
inside the firm thanks to barriers of entry that result from the high costs of
managing and coordinating such complex units.

The packaged nature of FDI can, in these circumstances, be the cause of a

highly skewed distribution of the gains from trade and investment unless local
bargaining power can bring a more balanced outcome, as it did for the first-tier
NIEs. However, replicating the success of early industrialisers is all the more
difficult where such investment is highly mobile: locational advantages are easily
won and lost through small cost changes or the emergence of alternative sites,
giving rise to the danger of enclave economies where there is a persistently
high dependence on imported intermediate and capital goods.

An important motive in seeking to attract FDI in export industries is its poten-

tial contribution to balance-of-payments. Indeed, as long as the entire produc-
tion is exported, participation in IPNs can make a positive contribution to the
balance-of-payments in developing countries, barring such practices as transfer
pricing, even if these activities are heavily dependent on imported parts and
components, and the value-added left in the country is no more than the wages
of unskilled labour. However, the picture can change when the goods and ser-
vices produced are sold in domestic markets.

More generally, the contribution of FDI to balance-of-payments varies inversely

with the share of profits in value-added, the extent of their reliance on imports,

34
and the proportion of the final product sold in domestic markets.20 In general,
since an important part of the value-added goes to profits, the import content is
high, and the goods and services produced are partly sold in domestic markets,
the contribution of FDI to balance-of-payments in developing countries is often
negative.

This is the case even in China, one of the most successful countries in attracting
export-oriented FDI. At the end of the 1990s, total profits earned by foreign-
funded enterprises (FFE) in China were in the order of $20 billion, of which
$12 billion was reinvested in the country and the rest was taken out. In the
same period, these enterprises generated a net export surplus of $2 billion. Thus,
the FFE sector as a whole was in the red by some $6 billion even on cash-flow
basis (Akyüz 2003, p. 144). Available evidence suggests that a similar situa-
tion existed in Malaysia in the late 1980s and early 1990s when such deficits
were covered by new FDI, in much the same way as engaging in a process of
Ponzi financing – that is, previous investors are paid with the money brought in
by new investors (UNCTAD 1999, pp. 120-123 and table 5.6).

20
Let :Q = (W + P) + (M + D) = X + S where Q stands for gross output, W for local wages, P for gross profits
on foreign investment, M and D for imported and domestically provided inputs respectively, X for exports and S
for domestic sales. The balance of payments effect is given by: B = (X -M) - P = (W + D) - S where B is the net
foreign exchange receipts. B is positive when domestic payments for wages and inputs exceed domestic sales. If
the activity is entirely export oriented (S=0), then the balance of payments effect is always positive regardless of
the import content of output and the division of the value-added between local wages and foreign profits. When
FDI is in non-traded good sectors (X=0), the balance of payments effect is always negative.

35
 7 Competition and the Fallacy of
Composition

As a result of the increased participation of several highly populated, low-in-

come countries in world trade in recent years, as much as 70 per cent of the
labour force employed in sectors participating in world trade is low-skilled.
Besides, there is still a considerable amount of surplus labour in such countries,
and many large countries are not yet fully integrated into the international trad-
ing system. Thus, a simultaneous export drive by developing countries in labour-
intensive manufactures, or increased competition among them to attract FDI as
locations for labour-intensive processes, could rekindle the fallacy of composi-
tion or the adding-up problem: on its own a small developing country can sub-
stantially expand its exports without flooding the market and seriously reduc-
ing the prices of the products concerned, but this may not be true for developing
countries as a whole, or even for large individual countries such as China and
India. The dangers of overproducing standardised mass products with high
import dependence are typified by the electronics sector, where developing coun-
try export prices appear to be more volatile and to have fallen more steeply after
1995 than similar products traded among developed countries.

There are also more general signs that the prices of manufactured exports from
developing countries have been weakening vis-à-vis manufactures exported by
industrialised countries in recent years (Akyüz 2003, pp. 83-92; Mayer 2003).
For instance it has been estimated that China’s net barter terms of trade in manu-
factures deteriorated by more than 10 per cent over the period 1993-2000, and
the deterioration was greater vis-à-vis developed than developing countries,
and more pronounced in products such as electronics and office equipment
(Zheng and Yumin 2002). Such evidence suggests that productivity gains in

36
labour-intensive manufactures exported by developing countries do not always
go to labour as higher wages, but benefit consumers in western markets in lower
prices. These trends suggest increased commoditisation of many labour-inten-
sive manufactures exported by developing countries.

Differences in the behaviour of prices of manufactures exported by developing

and developed countries appear to arise primarily from differences in global
market structures and domestic labour market conditions. Because of the exist-
ence of significant barriers to entry in technology-intensive product lines in-
cluding their high R&D contents and the high costs involved in organising pro-
duction chains, markets for such products are dominated by oligopolistic pro-
ducers in industrialised countries usually competing on the basis of quality,
design, marketing, branding and product differentiation, rather than price. In
such products, export market shares are much more concentrated than in manu-
factures exported by developing countries. This is also true for products that
require very large and specific investments, such as machinery or transport equip-
ment.

By contrast, there is much stiffer competition in markets for labour-intensive

manufactures produced by developing countries. While these products provide
opportunities for the new generation of industrialising economies, most middle-
income developing countries also persist in these sectors because their produc-
ers find it difficult to upgrade and diversify. Industrialised economies also con-
tinue to operate in such sectors behind protection, as weak growth and high
unemployment have slowed the closure of their sunset industries, thereby re-
stricting the size of the market for developing country producers.

Competitive pressures are further compounded by the way labour markets in

developing countries accommodate the additional supply of labour-intensive
manufactures through flexible wages, allowing firms to compete on the basis of
price without undermining profitability. Competition among firms, including
TNCs, in developing countries becomes competition among labour located in
different countries.

37
With a growing number of low-income developing countries, including some
with very large unskilled labour pools, turning to export-oriented strategies, the
middle-income countries in Latin America and Asia appear most vulnerable to
these dynamics. In particular, greater price competition in products of the elec-
tronics sector appears to have increasingly exposed traditional developing coun-
try exporters to the emergence of more competitive suppliers in countries with
lower costs. This is also expected to happen in textile and clothing with the
dismantling of non-tariff barriers. In the absence of a rapid upgrading to high-
skill, high value-added manufactures needed to enable them to compete with
more advanced industrial countries, the middle-income exporters may face a
squeeze between the top and bottom ends of the markets for manufactures.

These challenges facing developing countries in international trade have been

seen in recent years through the lens of international competitiveness. How-
ever, a degree of caution is needed in applying this concept in the present con-
text. In the first place, strictly speaking, the concept may be useful to define the
position of individual enterprises vis-à-vis each other, but not for comparisons
among economies as a whole or even among industries comprising many firms
with different characteristics: for, it is not countries but firms that trade (Krugman
1994). From a private perspective it may matter little whether the international
competitiveness of an enterprise is improved through productivity growth, wage
cuts or a devaluation of the currency, but from a broader socio-economic point
of view, these have totally different implications for economic growth, and so-
cial stability and welfare.

Evidence shows that wage suppression or sharp currency devaluations are not
viable responses to the emergence of low-cost producers. Many countries which
sought to increase the international competitiveness of their firms in this way
have failed to achieve sustained improvements in their manufactured export
and value-added performance. On the other hand, while productivity growth is
a more secure way of gaining a competitive edge for an individual country, a
simultaneous drive by a large number of countries to improve productivity and
gain competitiveness in labour-intensive manufactures can create gluts in the

38
markets for these products and, hence, run against the problem of fallacy of
composition, in much the same way as has happened in a number of primary
commodities.

39
 8 Policy Challenges

The basic policy issue facing developing countries in the trading system is not,
fundamentally, one of more or less trade liberalisation, but how best to extract
from their participation in that system the elements that will promote economic
development. In this respect policy challenges faced by countries differ ac-
cording to various factors including the stage of development reached, resource
endowments, size and geography.

For some the main challenge is switching from primary commodities while for
many others it is a question of advancing further in industrial development. In
the latter group, many countries, particularly those with large populations, still
have large numbers of unemployed workers, to be absorbed in industry and
services. Given the global glut in low-skilled labour, there is a risk of excessive
competition among developing countries in world markets for labour-intensive
manufactures and for FDI as locations for labour-intensive segments of IPNs.
This could disrupt the development process by causing significant terms-of-
trade losses and create serious frictions in the global trading system. A factor
increasing this risk is continued protectionism in industrial countries against
labour-intensive manufactures exported by developing countries.

It was estimated by UNCTAD (1999, chap. VI) that developing countries would
be able to earn an additional $700 billion per annum from exports of labour-
intensive manufactures if protectionist barriers in industrial countries were dis-
mantled. This amounts to some 50 per cent of earnings from manufactured
exports that the developing countries registered in recent years.

40
The mounting pressure in industrialised countries to raise the level of protec-
tion stems from the coincidence of high unemployment levels and growing
wage inequality in these countries with sharp increases in labour-intensive
manufactures exported by developing countries. These are sectors in which
industrial countries have no chance of regaining competitiveness even with a
major adjustment in wages, given that productivity in many developing coun-
tries in such sectors are relatively high and wage levels are considerably lower.

Rather than trying to address the difficulties arising from increased competition
by employing the full range of macroeconomic and structural policies to accel-
erate growth, upgrade skill levels and reduce unemployment, most industrial
countries have chosen to protect such industries by tariff and non-tariff barriers,
and abuse of anti-dumping measures and technical, health and safety standards.
Rolling back protectionism in such sectors would certainly provide consider-
able space for labour-abundant exporters of manufactures in the South, but it
remains to be seen whether major progress can be made in this area without a
return to high-growth, full-employment policies of the kind employed during
the 1950s and 1960s which greatly helped absorb the entry of low-cost produc-
ers such as Japan and Italy.

The persistence of several middle-income countries in labour-intensive manu-

factures is another reason for the excess supply in world markets for such prod-
ucts. Thus, industrial upgrading in more advanced developing countries would
help overcome difficulties in markets for labour-intensive products by allowing
new players to take over labour-intensive activities in world trade and by stimu-
lating trade among developing countries. This has happened to a certain extent.
Countries like China have gained much of the market share given up by the
first-tier NIEs when they shifted to more technology-intensive exports. How-
ever, because of the failure to undertake timely industrial upgrading, some ex-
porters in the middle-income countries have been negatively affected. Their
problems can be aggravated if large countries such as China and India rapidly
expand their exports in labour-intensive manufactures.

41
Upgrading in many of these middle-income countries extensively participating
in IPNs should involve the replacement of imported parts and components with
domestically produced ones. In this process, the shares of both imports and
exports in GDP would be expected to fall as domestic value-added grew faster,
reversing the trend observed in countries participating in IPNs.

What is needed here is that resources generated by employing surplus labour in

such networks should provide the basis for the expansion of indigenous pro-
duction capacity, entrepreneurship, skill and technology. Certainly, success
depends, to a large extent, on the policies pursued in areas such as trade, fi-
nance, industry and technology. Many of the policy measures successfully used
in the past for this purpose, not only by the first-tier NIEs but also by industri-
alised countries, are no longer available because of multilateral commitments
made by developing countries in the WTO, notably in TRIPS, TRIMs and sub-
sidies. Moreover, effective substitutes for such measures may not always be
easy to find.

There is, thus, a need to reconsider, in the WTO review process, the full impact
on development of limiting the policy options open to developing countries. It
is also important that developing countries resist attempts to narrow their policy
space further by extracting new commitments from them in areas such as FDI,
competition policy, government procurement and industrial tariffs, and use fully
the policy space available to them.

It is often suggested that services provide new opportunities for middle-income

countries with well-educated populations and skilled labour force in maintain-
ing growth momentum in the face of increased competition in labour-intensive
manufactures. However, expanding the services sector alone is unlikely to en-
sure income convergence with advanced countries except for economies with
massive hinterlands such as Hong Kong. The historical experience shows that
the services sector takes over and a process of benign de- industrialisation starts
at much higher income and productivity levels than those achieved by middle-
income countries; that is, around $9,000 (Akyüz, Kozul-Wright and Mayer 2004).

42
Indeed, a problem facing many developing countries today is that de-
industrialisation has been occurring and the share of services rising at much
lower levels of industrial productivity and per capita income. More important,
this has been happening in the context of erratic and slow growth. It would be
a fallacy to think that middle-income countries could converge towards the
income levels of highly industrialised countries by rapidly moving into ser-
vices, before achieving industrial maturity.

Similarly, the limits of services in providing new trade opportunities would

need to be recognised. A number of services, such as those related to data
processing, communication and health have been moving to middle-income
developing countries with required skills and infrastructure. However, the pros
and cons of this are very much like those entailed by participation in IPNs.
Their competitive edge in such services comes from lower wages. But low
wages have very little to do with the efficiency of labour in the services per-
formed. A data analyst or a doctor in India or Malaysia is not necessarily less
skilful or productive than their counterparts in Europe, but he or she earns a lot
less because the overall productivity of the economy is much lower. And for
most countries, there is no other way of raising overall productivity than indus-
trial development.

To avert potential difficulties in world markets for labour-intensive manufac-

tures, larger developing economies, such as China and India, will need to find
ways of utilising domestic sources of growth more fully. It is true that growth
of manufacturing and industrialisation in the first-tier NIEs depended heavily
on expansion of exports, particularly at the early stages of their development.
However, these countries were poor in natural resources, and this necessitated
a rapid move into labour-intensive manufacturing to earn the foreign exchange
needed for imports essential for development. Moreover, they were small in
size; collectively their population is smaller than that of Guangdong Province
in China. Thus, their industries needed to seek markets abroad in order to
achieve the necessary economies of scale in production.

43
Indeed, historical evidence demonstrates, in general, an inverse relationship
between trade orientation and economic size; among countries with similar
levels of per capita income, the ratio of trade to income tends to be lower in
countries with larger populations. Therefore, countries such as China and India
can rely less on foreign markets for their industrialisation than did the first-tier
NIEs. Indeed, the most dynamic markets for labour-intensive manufactures
can be established in these countries themselves provided that policies empha-
sise broad-based growth.

A strengthening of regional economic ties among developing countries could

also help avoid many difficulties they are facing at the global level. Conven-
tional economic thinking tends to dismiss regional arrangements as a second-
best solution for meeting development goals, and a potential stumbling-block
on the road to a fully open and integrated multilateral system. However, this
conclusion is based on a somewhat utopian view of the global economy.

Where domestic firms still have weak technological and productive capacities,
and the global economic context is characterised by biases and asymmetries,
regional arrangements may well provide a more supportive environment in which
to pursue national development strategies. In particular, for manufacturing sec-
tors which are traditionally oriented towards domestic markets, the regional
context is useful for learning to adapt to the pressures of international competi-
tion, and can provide a first step towards close integration into the world
economy.

In East Asia the regional pattern of industrialisation, sometimes described as a

“flying geese development paradigm”, has involved a progressively deeper re-
gional division of labour where trade and investment flows link countries at
different levels of development, and industries are relocated from one country
to another in response to shifts in productive capabilities and competitiveness
(UNCTAD 1996, Part Two, chap. I). While this process is driven primarily by
markets, policy has also an important role to play in facilitating integration and
ensuring its stability and sustainability.

44
In the current conditions of sharply increased global financial instability, greater
regional economic integration should also include increased monetary coop-
eration designed to ensure stability of the regional pattern of exchange rates.21
In this respect useful lessons can be drawn from the experience of Europe after
the collapse of the Bretton Woods arrangements, which allowed the region to
move successfully from various mechanisms designed for intra-regional ex-
change rate stability to the EMU and the introduction of the euro in 1999.

The arrangements should go beyond establishing a regional Fund with contri-

butions from reserves to help countries facing speculative attacks on their cur-
rencies, as proposed during the 1997 East Asian crisis. They should also aim at
reducing the likelihood of financial crisis and fluctuations among the bilateral
exchange rates, and helping expand intra-regional trade and prevent intra-re-
gional exchange rate conflicts of the kind observed in Mercosur during the
devaluation of the Brazilian real in 1999 (Fernández-Arias, Panizza and Stein
2002; Eichengreen 2002). Consideration should thus be given to effective in-
tra-regional surveillance over financial markets, macroeconomic policy coor-
dination, and mechanisms to sustain stable intra-regional exchange rates.

21
For a discussion of the issues involved see Akyüz and Flassbeck (2002).

45
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Titles in the TWN Trade & Development Series

No. 1 From Marrakesh to Singapore: The WTO and Developing Countries

by Magda Shahin (48 pages)

No. 2 The WTO and the Proposed Multilateral Investment Agreement: Implications for
Developing Countries and Proposed Positions by Martin Khor (40 pages)

No. 3 Some Key Issues Relating to the WTO by Bhagirath Lal Das (40 pages)

No. 4 The New Issues and Developing Countries by Chakravarthi Raghavan (48 pages)

No. 5 Trade and Environment in the WTO: A Review of its Initial Work and Future
Prospects by Magda Shahin (68 pages)

No. 6 Globalisation: The Past in our Present by Deepak Nayyar (40 pages)

No. 7 The Implementation of the WTO Multilateral Trade Agreements, the ‘Built-In’
Agenda, New Issues, and the Developing Countries by Xiaobing Tang (68 pages)

No. 8 Strengthening Developing Countries in the WTO by Bhagirath Lal Das (48 pages)

No. 9 The World Trade Organization and its Dispute Settlement System: Tilting the
Balance Against the South by Chakravarthi Raghavan (48 pages)

No. 10 Negotiations on Agriculture and Services in the WTO: Suggestions for

Modalities/Guidelines by Bhagirath Lal Das (24 pages)

No. 11 The Implications of the New Issues in the WTO by Bhagirath Lal Das (20 pages)

No. 12 Developing Countries, the WTO and a New Round: A Perspective

by Ransford Smith (40 pages)

No. 13 Review of the TRIPS Agreement: Fostering the Transfer of Technology to

Developing Countries by Carlos Correa (48 pages)

No. 14 The Proposed New Issues in the WTO and the Interests of Developing
Countries by Martin Khor (32 pages)

No. 15 WTO: Challenges for Developing Countries in the Near Future

by Bhagirath Lal Das (24 pages)

No. 16 Dangers of Negotiating Investment and Competition Rules in the WTO

by Bhagirath Lal Das (32 pages)

49
No. 17 WTO Agreement on Agriculture: Deficiencies and Proposals for Change
by Bhagirath Lal Das (28 pages)

No. 18 Some Suggestions for Modalities in Agriculture Negotiations

by Bhagirath Lal Das (24 page)

No. 19 The WTO Agriculture Agreement: Features, Effects, Negotiations, and

Suggested Changes by Martin Khor (48 pages)

No. 20 Market Access for Non-Agricultural Products: A Development View of the

Principles and Modalities by Martin Khor & Goh Chien Yen (32 pages)

No. 21 Financial Effects of Foreign Direct Investment in the Context of a Possible

WTO Agreement on Investment by David Woodward (28 pages)

No. 22 Implementation Issues Again Off WTO Radar Screens?

by Chakravarthi Raghavan (28 pages)

No. 23 Effects of Agricultural Liberalisation: Experiences of Rural Producers in

Developing Countries by Meenakshi Raman (40 pages)

No. 24 The WTO Negotiations on Industrial Tariffs: What is at Stake for Developing
Countries by Yilmaz Akyüz (68 pages)

No. 25 The Commodities Crisis and the Global Trade in Agriculture: Problems and
Proposals by Martin Khor (44 pages)

No. 26 Implications of Some WTO Rules on the Realisation of the MDGs

by Martin Khor (48 pages)

No. 27 Development Issues in the WTO in the Post-July Package Period: Myth or Reality?
by Bonapas Onguglo (72 pages)

No. 28 Trade, Growth and Industrialisation: Issues, Experience and Policy Challenges
by Yilmaz Akyüz (52 pages)

50
 TRADE, GROWTH AND INDUSTRIALISATION: ISSUES,
EXPERIENCES AND POLICY CHALLENGES
Over the past two decades, liberalisation of trade and investment flows has domi-
nated policy reforms in the developing world, in the belief that rapid and full inte-
gration into the global economy would create more favourable conditions for growth.
However, both theory and empirical evidence suggest no automatic linkage be-
tween trade liberalisation and growth.
This paper explains why this is so and, in this light, addresses the basic policy
challenge facing most developing countries: how to establish a broad and robust
industrial base as the key to successful development, and how best to channel trade
and investment to this end. The author finds that, while developing countries’ share
in world manufacturing exports – including high-tech products – appears to have
been expanding rapidly, incomes earned from such activities by these countries do
not share in this dynamism.
To be able to progress further along the development path, therefore, these devel-
oping countries need to undertake industrial upgrading and graduate from labour-
intensive to higher-value-added production, thereby also allowing still-less-advanced
countries to participate in manufacturing by taking over their activities. This paper
explores possible solutions to this problem, setting out policy suggestions as to
how developing countries can orient their participation in international trade and
production systems towards promoting economic development.
DR. YILMAZ AKYÜZ was the Director of the Division on Globalisation and
Development Strategies and Chief Economist at the United Nations Conference on
Trade and Development (UNCTAD) until his retirement in August 2003. He was
the principal author and head of the team preparing the Trade and Development
Report, and UNCTAD coordinator of research support to developing countries (the
Group of 24) in the IMF and the World Bank on international monetary and finan-
cial issues. Before joining UNCTAD in 1984 he taught at various universities in
Turkey, England and elsewhere in Europe. He has published extensively in macro-
economics, finance, growth and development. Since retiring from UNCTAD, he
has held the Tun Ismail Ali Chair in Monetary and Financial Economics, Univer-
sity of Malaya. His current activities include policy research for international
organisations, and advising governments on development policy issues, and the
Third World Network on research in trade, finance and development.

TWN TRADE & DEVELOPMENT SERIES

is a series of papers published by Third World Network on trade and de-
velopment issues that are of public concern, particularly in the South. The
series is aimed at generating discussion and contributing to the advance-
ment of appropriate development policies oriented towards fulfilling human
needs, social equity and environmental sustainability.

51